The “Gatekeeper” Approach to Hedge Fund Oversight

Date: Tuesday, March 20, 2007
Author: Hennessee Group Press Release

March 19, 2007 – New York, NY – Hennessee Group LLC, an adviser to hedge fund investors, released its opinion today on how to improve hedge fund investors’ protection and reduce systemic risk related to hedge funds.  Hennessee Group supports recent SEC action to increase the accredited investor level and recommends further considerations related to “gatekeepers” in accordance with prior recommendations Hennessee Group has made before the House of Representatives, Senate, SEC and CFTC between 1998 and 2005. 

Despite the recent decision not to directly regulate hedge funds, proactive indirect monitoring through coordination with “gatekeepers”, including prime brokers, accountants, administrators, investment banks and commercial banks (many of which are already under regulatory oversight or influence), can be a cost-effective alternative.   According to Hennessee Group research, the largest 100 hedge funds account for more than 50% of the industry’s total assets and pose the greatest threat to systemic risk.

Mr. Gradante further states that “the 100 largest hedge funds should be given the equivalent of ‘CUSIP numbers’ to track their activity through prime brokers and commercial banks, who in turn would report data to regulators, the Treasury, and the Fed.  This would allow significant transparency into the use of leverage and potential systemic risk.”  Most hedge fund leverage comes from two regulated sources: investment banks and commercial banks, both of which are regulated and can report leverage to regulators and government agencies.

According to Hennessee Group research, over 90% of U.S. hedge funds currently utilize one of 10 prime brokers who are registered broker dealers and regulated by the SEC and NASD.   Information about leverage and concentration can be gathered from this source. 

Through best practices or regulatory means, the following mandates would be an improvement for purposes of investor protection: a) monthly or quarterly third-party administrator services for domestic hedge funds to independently compute net asset values (NAV); and b) requiring accounting firms to send K-1 statements and annual audits directly to the limited partner, and not through the general partner.

To establish a level playing field for all investors, including retail investors who want to invest in hedge funds, the mandate for the new class of mutual funds that are currently permitted to replicate a long/short managed fund should be broadened.  In this way, the retail investor would receive regulatory protection imposed by the Investment Company Act of 1940 while achieving the benefits of diversification.

In addition, over 90% of all U.S. hedge funds use one of six accounting firms to perform annual financial audits, and more than half of U.S. offshore hedge funds currently use one of the top five administrators.  The uncertainties about the size of the hedge fund industry (in assets and leverage) can be answered by polling these accounting firms.

In conclusion, by capturing information from the “gatekeepers,” regulatory authorities and government agencies can gain transparency into the $1.442 trillion hedge fund industry in a cost-effective and timely manner without inhibiting the entrepreneurial spirit of the industry that provides liquidity, contrarian research and pricing efficiency to the markets.